(BAC) Bank of America Subpoenaed for Collateralized Loan Obligations Inquiry

Massachusetts state regulators are investigating whether Bank of America Corporation (BAC) has knowingly inflated the value of assets in two loan portfolios that BofA sold to the investors in the form of collateralized loan obligations (CLOs). These loan portfolios led to nearly $150 million of losses to the investors.

On Friday, Massachusetts Secretary of State William Galvin issued a subpoena to the unit of BofA, Bank of America Securities LLC for documents related to two CLOs – LCM VII Ltd. and Bryn Mawr CLO II – that were sold for a total of $865 million in July 2007. Bank of America Securities merged with Merrill Lynch after its acquisition in 2008.

CLOs are bundles of loans that are sold to investors in different tranches with varying degrees of risk. The Massachusetts regulators have been investigating as to how the banks structured and sold a large number of debt products, prior to the financial crisis in 2008. During the financial crisis, the value of many CLOs plunged as borrowers were unable to pay their loans.

A recent enquiry conducted by Securities Litigation and Consulting Group Inc., a Virginia based consulting firm, has come up with a data that shows that the value of the loans had already declined by about 4% by the time BofA sold these loans to the investors in 2007. Moreover, the company had failed to warn the investors about the fall in the loan values.

Furthermore, though it is still very early to name other banks against which investigations might start, Mr. Galvin affirmed that the state would investigate other pool of assets that were sold during that period, which resulted in losses to Massachusetts investors.

The issuing of a subpoena by Massachusetts came at the time when BofA along with four other banks – JPMorgan Chase & Co. (JPM), Citigroup Inc. (C), Ally Financial Inc. and Wells Fargo & Company (WFC) – agreed to the $25 billion foreclosure settlement deal. In 2010, JPMorgan, Bank of America and Ally Financial had temporarily suspended foreclosures across the country following the detection of flawed documents that were used to foreclose properties. This had led to a huge mess, which resulted into the launching of a probe by the U.S. bank regulators, along with a task force of attorneys general of all the 50 states.

Our Viewpoint

We believe that the inquiry by the state regulators will lead to proper disclosures of the value of the loans and other debts by the banks and other financial institutions, which they sell to the investors. Though the inquiry and the issue of subpoenas do not always lead to filing of litigation, they definitely dent the goodwill of the companies and create a financial impact on the companies’ results.

Currently, BofA retains a Zacks #3 Rank, which translates into a short-term Hold rating.

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